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Iceland's Economic and Financial Crisis: Causes, Consequences and Implications

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  • Spruk, Rok

Abstract

Iceland experienced a significant financial meltdown and subsequent economic downturn after the 2008/2009 financial crisis struck the country. It had been the worst crisis ever experienced by a small country from the late 20th century onwards. Since 1980s, Iceland's macroeconomic stability had been constantly deteriorated by the most volatile annual CPI and asset-price inflation dynamics in the OECD. More than a decade of robust growth dynamics left behind an internationally over-exposed banking sector which exceeded the size of country's GDP by nearly 10 times. The failure of Lehman Brothers and a global credit crunch, in turn, raised CDS rates on Icelandic banks which immediately declared insolvency after the global interbank lending froze. The paper provides a comprehensive analysis of the macroeconomic, banking and financial background of the crisis. It also provides a short-term analysis of Iceland's macroeconomic outlook. The main findings of the article conclude that the depth of financial crisis is attributed to the recent decade of unadjusted monetary policy which failed to prevent sharp appreciation of the krona and thus created sufficient conditions for significant asset-price inflation, high interest rate differential and the largest banking collapse in small and open economies. As the size of the banking sector was several times the country's GDP, Icelandic central bank failed to act as a lender of the last resort. The paper concludes that, to prevent future crises of similar proportions, it is impossible for a small country to have a large international banking sector, its own currency and an independent monetary policy.

Suggested Citation

  • Spruk, Rok, 2010. "Iceland's Economic and Financial Crisis: Causes, Consequences and Implications," MPRA Paper 29972, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:29972
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    File URL: https://mpra.ub.uni-muenchen.de/29972/1/MPRA_paper_29972.pdf
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    References listed on IDEAS

    as
    1. Ágeir Daníelsson & Lúdvík Elíasson & Magnús F. Gudmundsson & Björn A. Hauksson & Ragnhildur Jónsdóttir & Thorvardur Tjörvi Ólafsson & Thórarinn G. Pétursson, 2006. "QMM A Quarterly Macroeconomic Model of the Icelandic Economy," Economics wp32, Department of Economics, Central bank of Iceland.
    2. Steinar Holden & Fredrik Wulfsberg, 2007. "Are Real Wages Rigid Downwards?," CESifo Working Paper Series 1983, CESifo Group Munich.
    3. Mirko Abbritti & Andreas Mueller, 2007. "Asymmetric Labor Market Institutions in the EMU: Positive and Normative Implications," IHEID Working Papers 02-2009, Economics Section, The Graduate Institute of International Studies, revised Apr 2009.
    4. Peter Tulip, 2007. "Financial Markets in Iceland," OECD Economics Department Working Papers 549, OECD Publishing.
    5. Mongelli, Francesco Paolo, 2002. "ìNew" Views on the Optimum Currency Area Theory: What is EMU Telling US?," Royal Economic Society Annual Conference 2002 140, Royal Economic Society.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Iceland; Financial Crisis; Financial Macroeconomics; International Finance; Monetary Policy; Currency Crisis;

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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